Disney, the Master Acquirer: What Should It Buy Next, and What Should It Sell? | Top 15 Annual Report

Caught between the shifting fortunes of content and distribution, Disney still needs more great content and more new channels.

The Lucasfilm that Disney bought for $4 billion three years ago finally paid off in 2015. But that same year, Disney's money machine, ESPN, ran into trouble.

In the tug-of-war between Lucasfilm and ESPN, the problem Disney faces is really how to respond to a deeper shift in the entertainment industry: content is growing ever more dominant, and content is squeezing the margins of distribution.

That trend is clearest at Netflix. America's largest video-streaming service brags every quarter about how fast its subscriber numbers are growing, yet Netflix has still pushed into content production, spending $100 million to make House of Cards.

Netflix is a microcosm of every distribution-focused company in the entertainment industry. Pure video websites have yet to find a workable business model, pay-TV subscribers are declining, and movie theaters get by selling popcorn. No company that has managed to survive in this industry does distribution alone.

The companies that make content, on the other hand — the ones making movies and TV shows — keep growing stronger. On December 18, its North American opening day, Star Wars: The Force Awakens took in $120 million, the biggest single-day box office in film history.

Star Wars: The Force Awakens

In the entertainment industry, distribution is weakening and the value of content keeps rising. That trend is both good news and bad news for Disney.

On one hand, Disney is a content company: all four of its major brands — Disney, Pixar, Marvel, and Lucasfilm — started in film. On the other, Disney is also a distribution company, with its television networks, led by ESPN, as the most important piece.

The question before Disney is this: as both a content company and a distribution company, how should it respond to this shift? Put another way: for a company like Disney, which habitually solves problems through acquisitions and investments, what should it buy next, and what should it sell?

Disney's business is an IP business

Before answering that, let's look at what Disney actually does.

Of its roughly $50 billion in annual revenue, more than 40 percent comes from its television division — mostly advertising on its TV networks and pay-TV subscription fees.

The remaining divisions — film, theme parks, consumer products, games — look scattered, but they are really all in the same business: IP (intellectual property), the hottest term around right now.

IP can be understood simply as "stories": the story of Mickey Mouse, the story of Iron Man, the story of Star Wars. The IP business means selling those stories, whether through films and animated series or through theme parks and video games.

Disney can fairly claim to be the world's largest IP company. Every year it earns enormous sums across the entire IP value chain. The recently released Star Wars may be the best example.

Movies bring in the most revenue. On its first day in North American theaters, Star Wars: The Force Awakens grossed $120 million, breaking the all-time single-day box-office record. Given the film's near-perfect scores on Rotten Tomatoes, the franchise's final North American total could top $700 million.

Star Wars

Even before the film opened, sales of Star Wars toys and other merchandise had been underway for some time. Whether it was Disney's 18-hour global "unboxing" livestream on YouTube or the "Force Friday" Star Wars merchandise sale on September 4, fans queued for hours to buy.

Those products have already generated substantial revenue. After the third-quarter earnings call, Disney CFO Christine McCarthy told analysts: "Star Wars merchandise has sold extremely well, but certain accounting rules currently keep that from showing up in our financial statements."

Star Wars games have hit the market too, including Star Wars: Commander, a title with gameplay similar to Clash of Clans that launched last August, and EA's first-person shooter Star Wars Battlefront.

Finally, even Disney's theme parks are bringing in Star Wars. In August, Disney CEO Bob Iger announced at a fan convention that a Star Wars-themed land would be built at Disneyland in California — the largest themed area in any Disney park.

Star Wars is one of Disney's most important IPs. When Disney acquired Lucasfilm three years ago, 24/7 Wall St. predicted the franchise would bring Disney more than $30 billion in revenue. From where things stand today, that figure may not be far-fetched.

And the success of Star Wars is only a small slice of how Disney makes money. Mickey Mouse, Cinderella, Iron Man, Buzz Lightyear — these characters and their stories are endlessly adapted into films, animation, toys, theme parks, and games, all churning out enormous profits for Disney.

A collection of Pixar characters

The IP-centered business has also become Disney's fastest-growing. Year over year, profit from IP-related segments — film, parks, and consumer products — grew by more than 21 percent, far outpacing the 6 percent growth of the cable television division.

That figure again confirms the trend we keep describing: content growing more dominant, distribution growing weaker. As profits tilt increasingly toward content, distribution's once-unassailable place in the value chain comes under greater pressure. For Disney, that means ESPN.

Since IP is the real business, Disney could consider selling ESPN

This year, every Wall Street analyst fixed their attention on Disney's sprawling television business, led by ESPN. Even as Disney CEO Bob Iger insisted again and again that the TV business was healthy, he couldn't stop Wall Street from panicking.

The panic came from the declining leverage of cable networks. Last October, ESPN signed a new broadcast deal with the NBA. Starting with the 2016–17 season, ESPN's annual spending on the NBA alone would reach $1.47 billion — far above the roughly $485 million in the previous agreement.

Even the largest sports network in America has to bow to its content suppliers. Viewers want to watch the NBA, not ESPN, so ESPN has no choice but to swallow the NBA's steep demands to keep the broadcast rights.

As its leverage falls, so do cable-network subscriptions. According to figures Disney disclosed, ESPN's subscriber count dropped from 99 million two years ago to 92 million; Disney XD lost 4 million subscribers, and ABC Family lost 5 million.

Falling subscriptions mean falling revenue — both the fees subscribers pay and the advertising dollars that follow.

In this climate, ESPN has had to rein in costs. In late October, it announced layoffs of 300 employees and a restructuring of its business.

An ESPN studio

Layoffs don't mean ESPN will collapse overnight, but there's no disputing that its value as a distribution channel has slipped. So how should Disney handle its giant television business?

Our suggestion is that Disney weigh how each television channel relates to its core IP operations and consider bundling up and selling the ones where the link is weak.

The weak links include ESPN and news channels like ABC News. Their main value is as distribution — tens of millions of subscribers paying fees, plus the advertising that comes with them. They have little to do with Disney's IP. As more and more people watch television and news online, traditional cable revenue will inevitably fall, and selling these channels is a reasonable option.

A channel like Disney XD is different. This children's animation channel airs Star Wars and The Lion King cartoons and the like. For American audiences, these "childhood memories" cultivate new generations of fans, helping IPs like Star Wars and The Lion King keep their long-term vitality.

Selling the TV business comes at a steep price. Television currently accounts for roughly half of Disney's total revenue and profit. Sell it, and Disney's market value would shrink sharply — not something a company so attuned to Wall Street's reaction would welcome.

But since the entertainment industry's profit center is clearly shifting toward IP content, and Disney is already an IP-first company, selling the TV business could help it focus more sharply on managing IP.

What's more, after a sale Disney would be holding a great deal of cash. In a fast-changing era, there is no shortage of places for Disney to spend it.

Disney needs new channels to replace cable networks

Even if it sold off the TV networks, Disney would still need distribution of its own — it has to get its films and shows in front of as many people as possible. So beyond keeping channels like Disney XD, Disney needs to build new ones, and that takes serious money.

Over the past two years, Disney has been trying out new channels: investing in the video website Hulu, launching new paid channels with Sony's PlayStation Vue, rolling out its own streaming app DisneyLife in the UK, and co-developing an internet TV set-top box, "Disney Vision," with Alibaba.

The internet TV set-top box developed by Disney and Alibaba

These new channels should be more competitive than Disney's traditional cable networks, because most are built on mobile or the internet and can therefore draw more young viewers.

Here too, Disney faces competition. How to keep users on Hulu rather than handing them to YouTube; how to get viewers to subscribe to PlayStation Vue rather than Apple TV; how to keep them on DisneyLife rather than Amazon Instant Video — these are the questions Disney has to answer.

The competitive landscape is more complicated than it looks, though. Disney's distribution rivals fall into two camps. The first can be called pure distributors.

Here we find Apple TV, YouTube, Amazon Instant Video, and the like. They all started as distributors and are now moving into content production.

The most successful is probably Netflix. By the company's latest count, Netflix has 69 million subscribers, having added more than 15 million in the past year alone.

That fast subscriber growth is the biggest advantage of these new distributors. Yet as profits across the entertainment industry concentrate more and more in content, even these new distributors can't avoid starting to make content of their own.

In 2013, Netflix made its name with House of Cards, which it financed to the tune of $100 million; the show also brought in plenty of subscribers. By one estimate, 5 to 15 percent of Netflix subscribers watched at least one episode.

Netflix makes content to draw more users to its platform — that is the defining trait of distributors like Netflix. So this kind of competitor is willing to work with all sorts of content companies in order to pull in more users.

That creates openings for Disney. Because Disney owns popular content, these platforms want to license its films and shows, or even co-produce with it. Netflix has already struck a deal with Disney to co-develop four superhero series; Daredevil has done well in both ratings and reviews.

A still from Daredevil

Whether by licensing its content to new channels or co-developing projects with them, Disney can lean on its content strength to partner with these new distributors and hold on to its influence. For now, new distributors of the Netflix type pose no real threat to Disney.

But the second camp of distribution rivals is another matter. These companies started in content and built their own channels. The likes of Vice, BuzzFeed, and HBO are selling content first, which puts them in more direct competition with Disney. We might even count Oculus, which wants to make virtual-reality films, and video-game makers like EA.

The more serious problem comes from content

Take Disney versus Vice as an example of how they go head-to-head. On the surface: young people love being online, so Vice's short videos there have lured them away. Young people don't watch TV, so subscriptions to Disney's cable channels are falling. By this reading, Disney and Vice are competing over distribution.

But there's another way to see it. Vice's short videos simply appeal more to young people, so they go online to watch Vice. Disney's animated films appeal to them less, so they don't watch TV. From this angle, Disney and Vice are competing over content.

The Vice project that recently caused a stir in China was a documentary about Edison Chen

Both readings hold up — Disney and Vice compete on both distribution and content. But we believe content competition is the root cause of distribution competition, because content determines distribution.

To see why content determines distribution, consider a few examples: films can only screen in cinemas; TV series appear on television screens; video games need a computer; Disneyland can only be experienced in person, in California or Hong Kong. These show that how content is presented determines its channel.

A few more examples. Someone selling custom massage chairs to the elderly won't go pitch them at a kindergarten. By the same token, the studio behind Pleasant Goat and Big Big Wolf won't hold a screening for seniors at a retirement home. What story a piece of content tells also determines which channel it needs.

The Disney-Vice rivalry clearly belongs to the second category. Vice offers content that appeals more to young people, then puts it on the internet, where young people like to be. It pulls them onto its own site, and so fewer people watch cable. Vice has taken away the young audience Disney wants to reach.

The Disney-Oculus and video-game rivalry belongs to the first category. Young people prefer virtual reality, so they buy Oculus headsets and play the VR games these makers develop. They leave the movie theater, and Oculus, too, has taken the young audience Disney wants.

So to compete with this second type of company, Disney doesn't need to expand its distribution channels; it needs to develop new content. "New content" has two dimensions: what stories Disney wants to tell, and how it wants to tell them.

The stories themselves need refreshing — and that, too, takes money

First, the question of what stories Disney wants to tell.

This was once Disney's biggest headache. Before 2005, its animation studio had gone years without making a film that truly moved audiences; its live-action output was no better, and the whole company was in crisis.

Then CEO Bob Iger saved Disney by acquiring Pixar and Marvel. Iron Man, Captain America, WALL-E, Up — these great stories carried Disney through the crisis.

Disney knows its strength is telling a great story. But great stories don't come on demand. In recent years, Pixar has hit a creative drought — Brave and The Good Dinosaur were not real successes. And Marvel's superhero saga is starting to wear audiences out.

The Good Dinosaur, released this Thanksgiving, may be Pixar's worst film

The newly released Star Wars seems to carry a fresh energy. But the franchise has its own problems.

Before the film opened, longtime fans accused Disney of not taking Star Wars seriously — and even of possibly ruining it. With younger audiences, the franchise looks underpowered. The Star Wars prequel trilogy began in 1999, more than a decade ago, and the generation that grew up since then may not be sold.

In the Chinese market, Disney brought five hundred stormtroopers to the Great Wall and lit up the four Chinese characters for "The Force Awakens" along it. Most people just exchanged blank looks, figuring Disney had cooked up another piece of overwrought publicity.

So Disney still needs more great stories.

Its answer, as usual, is to buy them. "Disney has been a bit opportunistic here," said Jay Rasulo, Disney's former CFO, describing the company's approach to acquiring new content. In Bob Iger's words: when something good comes along, they go buy it.

And Disney has bought a lot lately. Last March, it spent $1 billion to acquire Maker Studios, a company that bills itself as YouTube's largest video supplier, signing popular YouTube creators and developing series of its own.

PewDiePie, the most popular gaming video creator on YouTube, is also signed to Maker Studios

This November, Disney also paid $400 million for a stake in Vice, currently the most popular site among young people, full of videos and articles about youth subcultures — including the Edison Chen documentary that went viral in China.

Buying is easy. But turning these acquisitions into successful IPs is something Disney is still far from doing.

Take Maker Studios: when it acquired the company, Disney solemnly declared it hoped Maker would become a studio on the level of Marvel. So far, Maker Studios still feels more like an ordinary YouTube channel; beyond YouTube — in film and television — its presence remains remarkably thin.

Vice isn't there yet either, even though early next year it will launch its own channel on a TV network Disney controls.

Perhaps only Star Wars can really be called a success, but that's mostly because over the past three decades the franchise already built up plenty of brand recognition and a track record in merchandise development. In other words, Star Wars was already a mature IP going in, with precedents across film and TV production, toy and merchandise licensing, and game development. Disney simply had to follow the paths already laid out.

Disney still has to keep scouring the market for the next IP that can match Star Wars's success. So far, it hasn't found one.

The storytelling technology needs upgrading too — and that takes a lot of money

Now the second question: how does Disney want to tell its stories?

In Disney's current setup, there are roughly five ways to tell a story: theme parks, video games, films, television, and toys.

Of these, theme parks may be the most easily made obsolete. A telling episode came in 2005, when Disney launched an online game that simulated the Disney theme-park experience. When Disney decided to shut it down in 2008, players protested fiercely.

That episode gave Disney a sharp sense of danger: maybe video games would one day replace theme parks. If that day came, the tens of billions of dollars Disney had poured into its parks would become worthless.

So Disney began looking for ways to improve how its parks tell stories. In 2011, a board led by Bob Iger approved a plan to develop the MagicBand, with an initial budget of $1 billion.

The MagicBand can be thought of as a wearable device for getting around Disneyland. You can use it as your hotel room key, a payment pass, even a form of ID.

The MagicBand, which cost Disney $1 billion

Disney says the MagicBand is working. "Thirteen million guests have already used the MagicBand," CFO Christine McCarthy told analysts. "Because the MagicBand has become part of the Disney parks experience, we can't quantify exactly how much revenue it has brought the parks."

The MagicBand can be used to tell stories: in a ride called Test Track, while waiting in line, guests can use their MagicBand to choose the color, styling, and engine of their own race car. When they board the ride, they find their custom car appearing on the screens around them. Here, the MagicBand has been woven into the story Disneyland tells.

But many people don't see it that way. In a Fast Company report, a park employee was quoted saying: "It's pretty obvious the MagicBand isn't all that magical."

Their argument: a theme park's real magic is that it carries you into a magical world; the rides and the design of the whole park tell you a magical story. But the MagicBand, with its technological, modern feel, actually breaks the consistency of that story — it pulls you out of it.

That is also why the MagicBand stirred its biggest controversy during development. The park's Imagineers and the MagicBand team clashed over it more than once.

Here you can clearly feel how, in some ways, technology and Disney's "dream-making" are at odds.

Whether or not the MagicBand is a success right now, it will end up as one of the props Disney uses to tell stories. The decision to develop it reflects a Disney resolve: to use the latest technology to tell the stories it has always told.

Disney has done a great deal on this front. First, video games: whether through partnerships with companies like EA and Kabam or through its own Disney Infinity, the approach has been to place existing stories into a new medium.

Star Wars Battlefront is a shooter in which players join the clash between the Empire and the Rebel Alliance. In Kabam's Marvel: Contest of Champions, players take on the roles of Marvel superheroes.

Also worth mentioning is Disney's Playmation line, which the company calls fourth-generation toys, because they amount to augmented reality.

When players put on the "Iron Man Gauntlet," they can follow the gauntlet's commands to punch at empty air, as if enemies were really there. The gauntlet also tracks your movements and position, judging whether an attack lands and whether you've been hit.

The Iron Man Gauntlet version of the Playmation toy

Closely related to augmented reality is virtual reality. In September, Disney also took part in the Series C round of the VR company Jaunt. The technology isn't mature yet, but it could eventually be used in films, television, games, even Disney's theme parks, upgrading how Disney tells stories still further.

You can see Disney's effort here, but it hasn't necessarily paid off. Take Disney Interactive, the division behind its video games: in the second quarter of 2015, its revenue plunged $58 million to $208 million, dragged down by falling sales of Disney Infinity. And against Disney's roughly $50 billion in annual revenue, Disney Interactive's contribution barely registers.

As for virtual reality, it's still hard to see exactly how the technology will be applied, or when it will scale. Whether VR films or VR games, ordinary consumers are a long way from adopting them.

When it comes to putting new technologies to work in storytelling, Disney clearly isn't fully in command yet. As with the MagicBand in the parks, Disney knows this is where the future lies, but it still struggles to convince its stubborn Imagineers that the traditional way parks tell stories needs an upgrade.

What Disney should buy, and what it should sell

To close, let's return to what Disney should buy and what it should sell. As its center of gravity shifts ever more clearly toward IP operations, Disney should sell off some of its older distribution assets, like the cable TV networks it still holds.

And as an IP company, what Disney needs to buy is outstanding IP — and the technology that helps it turn that IP into a good story.

In a Hollywood where creative talent is ever scarcer, few quality IPs are still on the market. Harry Potter and The Lord of the Rings were turned into films long ago. Divergent and Fifty Shades of Grey have already been snapped up. What's left is slim pickings.

On the technology side, Disney has already invested in a VR company; buying a few more game companies might be a good next move.

Buying may sound easy, but it's hard work. Disney's advantage here is money. Its most recent financial report showed $6.6 billion in cash on hand. Disney's high share price, together with market expectations around Star Wars and the opening of Shanghai Disneyland, could help it raise still more capital in the markets.

Disney's weakness is its caution. That caution shows in its acquisitions: although Disney bought Pixar, Marvel, and Lucasfilm in quick succession over the past decade, all three were already huge successes in the market. Toward companies still finding their footing, Disney has been far more hesitant. When Disney's talks with BuzzFeed broke down last April, many were left disappointed.

The same caution shows internally, in how the company takes up new things. Pixar co-founder Ed Catmull once declared that virtual reality is not suited to film. The park designers' resistance to the MagicBand likewise shows how hard change and innovation are inside Disney.

Fortunately, Disney still has time. As things stand, both Marvel and Star Wars should be able to carry through to around 2020. But five years isn't really that long — and the window for Disney to keep wavering is closing.

About the Top 15

Every era has companies that gather the most capital and the best talent, shaping the direction of society as a whole. QDaily believes that the companies shaping how we live are at the core of today's commercial world.

So we have selected 15 companies — globally and in China — most important to how people live: Apple, Google, Baidu, Alibaba, Tencent, Amazon, Disney, McDonald's, Starbucks, Nike, Xiaomi, IKEA, Uniqlo, Vanke, and Wanda. This list will change as company performance, markets, and trends shift. We will follow these companies, and their competitors and partners as well.

Over roughly the next month, we will keep publishing our 2015 Top 15 annual series.